Planning for Reinvestment of Carried Interest

December 18, 2018

The Tax Cuts and Jobs Act changed the treatment of “carried interest” received by managers of investment funds effective for gains realized on or after January 1, 2018.

Under these rules, a taxpayer’s distributive share of partnership gain from an “applicable partnership interest” will be treated as short-term capital gains (which are taxed at higher ordinary income rates) to the extent such gains result from the sale or exchange of an asset held by the partnership for three (3) years or less.

An “applicable partnership interest” is an interest transferred to the taxpayer for the performance of substantial services involving developing or investing in certain investment assets, including stocks, securities, commodities and real estate. This definition would cover general partner and special limited partner interests in private investment funds.

These rules have the potential to cause a substantial amount of incentive allocation income (that had in the past been allocated to the general partner or special limited partner of an investment fund as long-term capital gains) to be treated as short-term capital gains. The highest marginal income tax rate applicable to short-term capital gains is 37%. Long-term capital gains are subject to a maximum tax rate of 20%.

This three-year holding period requirement does not apply to the extent of investment professionals’ capital investments in their own funds. Such investments remain subject to the one-year holding period for long-term capital gains.

It is unclear how the reinvestment of carried interest by a general partner (or a special limited partner) into an investment fund will be treated under these rules. In the absence (to date) of IRS guidance on this point, fund managers will want to carefully consider how they structure the reinvestment of carried interest in their funds.

Managers who are interested in how the bill may affect their specific situations and their year-end tax planning should call us to understand fully the various factors they may wish to consider.